The Income Statement, From Revenue Down to Earnings Per Share

Item 1 of any Form 10-Q, under the heading “Financial Information,” holds the financial statements, and the one most readers go looking for carries a heading like “condensed consolidated statements of operations.” Some companies call it the statement of income or the statement of earnings. Same document. It tells you what the company sold during the period, what it spent, and what was left for shareholders once the lender and the tax authority took their shares.

You already know the headline version. Revenue up, earnings per share beat or miss. The statement underneath is where you find out why.

Where the statement sits in a 10-Q

The 10-Q is the quarterly report a US-listed company files with the SEC for each of the first three quarters of its fiscal year; the fourth quarter is folded into the annual Form 10-K. The statements in a 10-Q are condensed and unaudited, though an outside accountant usually reviews them. Look at the column headings first. A typical statement of operations shows “three months ended” for this year and last, then a year-to-date pair, so you can compare the quarter with the same quarter a year ago without seasonal noise getting in the way.

The notes to the statements follow straight after. Item 2, management’s discussion and analysis, is where the company explains in words why the lines moved. Read the numbers first, then Item 2, and see whether the story matches the arithmetic.

From revenue to gross profit

Take a hypothetical company, figures in millions. Revenue, the top line, is $1,000. Cost of goods sold is $600: the materials, labor and freight tied directly to what was sold. Subtract it and gross profit is $400.

Gross margin is gross profit divided by revenue. Here that’s 40%.

That percentage tells you how much of each sales dollar survives the cost of producing it, which matters more than the dollar amount when you compare quarters of different size or companies of different size, because a 40% gross margin on $1,000 million and a 40% margin on $100 million describe the same pricing power at very different scale.

Operating income: the business before financing

Operating expenses come next. Selling, general and administrative costs, research and development, and depreciation where it isn’t already in cost of goods sold all land here. In the example they total $250. Operating income is $400 minus $250, or $150, and operating margin is $150 divided by $1,000, which is 15%.

This is often the line worth reading first, because it shows what the business earns before anyone asks how it was financed or taxed. The column on why operating margin deserves the first look makes that case in full.

Interest, tax and net income

Interest expense of $20 comes off next, leaving pre-tax income of $130. Assume a hypothetical tax rate of 21%. Tax is $27.3, and net income is $102.7.

Net income is the bottom line. It’s also the line most exposed to one-off items, such as a lawsuit settlement or a gain on selling a building. When net income jumps and operating income doesn’t, look for the one-off.

Basic against diluted EPS

Earnings per share divides net income by the share count. Basic EPS uses the weighted average number of shares outstanding during the period, weighted because shares issued or bought back partway through only count for the part of the quarter they existed. In the example, 50 million shares turn $102.7 million into $2.05.

Diluted EPS adds the shares that stock options, restricted stock units and convertible securities could create. Suppose those add 4 million shares. Diluted EPS is 102.7 divided by 54, or $1.90.

Headlines usually quote the diluted figure.

The gap between the two is worth a glance each quarter, since a company that pays heavily in stock sees its diluted count creep up, and that creep lowers what each existing share earns even while net income stays exactly where it was. Buybacks run the other way. Cut the share count to 48 million with the same $102.7 million of net income and EPS rises to about $2.14.

The business didn’t earn a cent more.

What the income statement leaves out

The income statement records revenue when it is earned and costs when they are incurred, which is not the same as when cash changes hands. A company can book a sale in March and collect in June. It says nothing about debt levels either, or how much cash is sitting in the bank. For the gap between sales and profit, the answer on revenue against earnings works through the common causes, and the profit margin calculator works out each margin from the figures you enter.

What the company owns and owes is a separate statement, and the balance sheet is where the course turns next, with the equation that holds every one of its lines together.